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Auditors: The Leash Gets Shorter

For years, Sun Microsystems Inc. (SUNW) looked to its auditor, Ernst & Young International, to provide all manner of advice on other financial matters. But recently the Santa Clara (Calif.) high-tech company has started to shop elsewhere. PricewaterhouseCoopers now handles Sun's internal audit, KPMG International helps test financial controls, and Deloitte Touche Tohmatsu prepares tax returns for Sun's expatriate employees. With new federal rules beefing up the audit process, "it's our firm belief that [Ernst & Young] should focus specifically on the audit," says Stephen T. McGowan, Sun's chief financial officer.

Sun is not alone. After auditors failed to catch financial fraud at Enron and WorldCom (now MCI), Congress ordered companies to quit hiring their auditors for a slew of services, from bookkeeping to computer-systems design. The 2002 Sarbanes-Oxley corporate-reform act left it up to boards' audit committees to decide whether the same accounting firm could provide other services -- including tax advice. But with audit committees eager to avoid any chance for conflicts, more companies, from General Electric to Home Depot to American Express, are switching their tax work, too.

Now they have another reason to play it safe. On Dec. 14, the Public Company Accounting Oversight Board proposed stricter curbs on audit firms selling tax services to their clients. The board, created by Sarbanes-Oxley, says it wants to ban auditors from promoting aggressive tax shelters to client companies and their top execs. It also wants to keep them from accepting contingent fees, payments based on a percentage of their clients' tax savings. Also off limits: offering tax services to top company officers. The rules, which must be approved by the Securities & Exchange Commission, "draw clear lines to distinguish inappropriate services that impair auditor independence from permissible services that are not detrimental," says PCAOB Chairman William J. McDonough.

Investors are ahead of regulators. For the past two years, Institutional Shareholder Services, a proxy-advice service, has urged the investors it advises to vote against rehiring auditors who collect more in consulting fees than they do from the audit and audit-related work. The share of Standard & Poor's 500-stock index companies failing that test fell from 60% in 2002 to just 2% this year.

INCREASED COMPETITION

The Sarbanes-Oxley restrictions, along with better disclosure, drove much of that improvement, but boards are going beyond the law's strictures. "When in doubt, I want to turn away from the audit firm for anything except auditing," says professor Paul R. Brown of the Stern School of Business at New York University, who also sits on the audit committee of French aerospace company Dassault Systèmes.

The upshot: The average amount a large U.S. company paid its auditor for tax services fell 14%, to $1.9 million, in 2003, according to a study by Glass, Lewis & Co., a proxy-research firm. Jonathan Hamilton, editor of Public Accounting Report, figures tax fees could fall 5% to 10% in 2005 if the SEC blesses the new rules.

Critics have long accused the Big Four firms of underpricing their audits so they can charge hefty fees for consulting. But as businesses pull back tax work and offer it to the competition, rates are falling. Sun, which was paying Ernst & Young $3.5 million a year for expatriate tax services, found Deloitte was willing to do the work for just under $3 million.

The Big Four aren't necessarily losing out. Audit fees are rising as accountants scrutinize financial statements more extensively, and consulting work taken from the auditor usually ends up at another Big Four firm. Still, second-tier accounting firms and lawyers are gaining. Grant Thornton International, for example, recently took on state and local tax assignments from R.R. Donnelley & Sons Co. and Marriott International Inc.

The downside to spreading the consulting work: With only four international firms to choose from, a multinational can't switch auditors without having to reshuffle consultants for its tax, info-tech, and human-resources departments. Still, investors will be better off if auditors' independence isn't compromised by fat fees for other services.

Corrections and Clarifications

Below the headline on "Auditors: The leash gets shorter" (News: Analysis & Commentary, Dec. 27-Jan. 3), it was stated that accounting firms would no longer be allowed to perform tax services for companies they audit. Such services have been limited but not prohibited.